SENSITIVITY TO MARKET RISK Section 7.1 INTRODUCTION.............................................................. 2 TYPES AND SOURCES OF INTEREST RATE RISK .... 2 Types of Interest Rate Risk ............................................ 2 Sources of Interest Rate Risk ......................................... 2 RISK MANAGEMENT FRAMEWORK .......................... 3 Board Oversight ............................................................. 4 Senior Management Oversight ....................................... 4 Policies and Procedures .................................................. 4 Interest Rate Risk Strategies .......................................... 4 Risk Limits and Controls ................................................ 5 Risk Monitoring and Reporting ...................................... 5 INTEREST RATE RISK ANALYSIS ............................... 5 INTEREST RATE RISK MEASUREMENT METHODS 6 Gap Analysis .................................................................. 6 Duration Analysis ........................................................... 7 Earnings Simulation Analysis ........................................ 8 Economic Value of Equity ............................................. 8 STRESS TESTING ............................................................ 9 INTEREST RATE RISK MEASUREMENT SYSTEMS10 Measurement System Capabilities ............................... 10 System Documentation ................................................ 11 Adequacy of Measurement System Inputs ................... 11 Account Aggregation ................................................... 11 Assumptions ................................................................. 12 Sensitivity Testing - Key Assumptions ........................ 12 Measurement System Reports ...................................... 14 Measurement System Results ....................................... 14 Variance Analysis ........................................................ 14 Assumption Variance Analysis .................................... 15 OTHER RISK FACTORS TO CONSIDER .................... 16 Interest Rate Risk Mitigation ....................................... 16 INTERNAL CONTROLS ................................................ 17 Independent Reviews ................................................... 18 Independent Review Standards .................................... 18 Scope of Independent Review ...................................... 18 Theoretical and Mathematical Validations ................... 19 EVALUATING SENSITIVITY TO MARKET RISK .... 20 Examination Standards and Goals ................................ 20 Interagency Policy Statement on Interest Rate Risk .... 20 Interagency Advisory-Interest Rate Risk Management 21 EXAMINATION PROCESS ........................................... 21 Citing Examination Deficiencies .................................. 21 MARKET RISK GLOSSARY ......................................... 22 Deterministic Rate Scenarios ....................................... 22 Non-parallel Yield Curve Shifts ................................... 22 Static Models ................................................................ 22 Dynamic Models .......................................................... 22 Stochastic Models ........................................................ 22 Monte Carlo Simulation ............................................... 22 Spread Types ................................................................ 23 Duration Calculations ................................................... 23 Convexity ..................................................................... 24 Effective Duration and Effective Convexity ................ 24 RMS Manual of Examination Policies 7.1-1 Sensitivity to Market Risk (7/18) Federal Deposit Insurance Corporation SENSITIVITY TO MARKET RISK Section 7.1 INTRODUCTION Basis risk is the risk that different market indices will not move in perfect or predictable correlation. For example, Sensitivity to market risk reflects the degree to which LIBOR-based deposit rates may change by 50 basis points changes in interest rates, foreign exchange rates, while prime-based loan rates may only change by 25 basis commodity prices, or equity prices can adversely affect a points during the same period. financial institution’s earnings or capital. For most community banks, market risk primarily reflects exposure Yield curve risk reflects exposure to unanticipated to changing interest rates. Therefore, this section focuses changes in the shape or slope of the yield curve. It occurs on assessing interest rate risk (IRR). However, examiners when assets and funding sources are linked to similar may apply these same guidelines when evaluating foreign indices with different maturities. For example, a 30-year exchange, commodity, or equity price risks. A brief Treasury bond’s yield may change by 200 basis points, but discussion of other types of market risks is included at the a 3-year Treasury note’s yield may change by only 50- end of this section. basis points during the same time period. This risk is commonly expressed in terms of movements of the yield Market risks may include more than one type of risk and curve for a type of security (e.g., a flattening, steepening, can quickly impact a financial institution’s earnings and or inversion of the yield curve). the economic value of its assets, liabilities, and off-balance sheet items. In order to effectively manage IRR, each Option risk is the risk that a financial instrument’s cash institution should have an IRR management program that flows (timing or amount) can change at the exercise of the is commensurate with its size and the nature, scope, and option holder, who may be motivated to do so by changes risk of its activities. in market interest rates. Lenders are typically option sellers, and borrowers are typically option buyers (as they The adequacy of a bank’s IRR program is dependent on its are often provided a right to prepay). The exercise of ability to identify, measure, monitor, and control all options can adversely affect an institution’s earnings by material interest rate exposures. To do this accurately and reducing asset yields or increasing funding costs. effectively, institutions need: For example, assume that a bank purchased a 30-year • Appropriate IRR policies, procedures, and controls; callable bond at a market yield of 10 percent. If market • Sufficiently detailed reporting processes to inform rates subsequently decline to 8 percent, the bond’s issuer senior management and the board of IRR exposures; will be motivated to call the bond and issue new debt at the • Comprehensive systems and standards for measuring lower market rate. At the call date, the issuer effectively and monitoring IRR; and repurchases the bond from the bank. As a result, the bank will not receive the originally expected yield (10 percent • Appropriate internal controls and independent review for 30 years). Instead, the bank must re-invest the procedures. principal at the new, lower market rate. ← Price risk is the risk that the fair value of financial TYPES AND SOURCES OF INTEREST instruments will change when interest rates change. For RATE RISK example, trading portfolios, held-for-sale loan portfolios, and mortgage servicing assets contain price risk. When IRR can arise from a variety of sources and financial interest rates decrease, the value of an institution’s transactions and has many components including repricing mortgage servicing rights generally decrease because the risk, basis risk, yield curve risk, option risk, and price risk. total cash flows from servicing fees decline as consumers refinance. Because servicing assets are subsequently Types of Interest Rate Risk measured at fair value, or carried at amortized cost and tested for impairment, the fair value adjustment or any Repricing risk reflects the possibility that assets and impairment is reflected in current earnings. liabilities will reprice at different times or amounts and negatively affect an institution’s earnings, capital, or Sources of Interest Rate Risk general financial condition. For example, management may use non-maturity deposits to fund long-term, fixed- Funding sources may involve repricing risk, basis risk, rate securities. If deposit rates increase, the higher funding yield curve risk, or option risk, and examiners should costs would likely reduce net yields on fixed-rate carefully evaluate all significant relationships between securities. funding sources and asset structures. Potentially volatile or market-based funding sources may increase IRR, especially when matched to a longer-term asset portfolio. Sensitivity to Market Risk (7/18) 7.1-2 RMS Manual of Examination Policies Federal Deposit Insurance Corporation SENSITIVITY TO MARKET RISK Section 7.1 For example, long-term fixed-rate loans funded by partially or fully prepay the loan. purchased federal funds may involve repricing risk, basis • Mortgage-backed securities (MBS): Borrowers’ risk, or yield curve risk. As a result, interest rate options to prepay individual mortgage loans included movements could cause funding costs to increase in an MBS loan pool can shorten the life of a tranche substantially while asset yields remain fixed. of loans within a security. Derivative instruments may be used for hedging but can Embedded options can create various risks, such as introduce complex IRR exposures. Depending on the contraction risk, extension risk, and negative convexity. specific instrument, derivatives may create